The Court of Appeals of Colorado affirmed a lower court ruling providing that pipelines and fittings located in one of Colorado’s enterprise zones, which are used to gather and deliver natural gas from a taxpayer’s wells to its’ processing facilities, qualify for Colorado’s sales tax exemption because these items of machinery “are in direct use in the manufacturing of natural gas.” (Pioneer Natural Resources USA Inc. v. Colorado Department of Revenue, 2014 COA 101 (Colo. App. Div. I 2014)).

Factual background

Pioneer Natural Resources USA Inc. (Pioneer) was assessed a sales tax deficiency by the Colorado Department of Revenue (CDOR) for tax years 2003 and 2004. The CDOR determined that the pipelines and fittings used by Pioneer were not exempt from Colorado sales tax because these items do not extract or process natural gas or constitute manufacturing within the meaning of the Colorado sales tax statutes. After having appealed the CDOR’s ruling, Pioneer filed a complaint for judicial review in Colorado district court, and the court granted summary judgment in favor of Pioneer.

Pioneer operates over 2,000 wells and ten compressor or processing sites in the Raton Basin, which is located in Colorado’s South Central Enterprise Zone. Pioneer employs a gathering system of pipelines and fittings to maintain pressure in the system, extract natural gas from the ground, and move gas to the processing stations before entering a pipeline for commercial distribution.

Colorado’s manufacturing sales and use tax exemptions

Under Colorado’s general manufacturing sales and use tax exemption statute, “purchases of machinery or machine tools in excess of $500 are exempt from sales tax if they are used in Colorado directly and predominately in manufacturing tangible personal property for sale or profit…” Colo. Rev. Stat. § 39-26-709(1)(a)(II). “Machinery used during the manufacturing process to move material from one direct production step to another in a continuous flow…” is directly used in manufacturing. Colo. Rev. Stat. § 39-26-709(1) (d).

Colorado’s enterprise zone sales and use tax exemption statute is also applicable if machinery is “solely and exclusively in an enterprise zone…” Colo. Rev. Stat. § 39-30-106(1) (a). This statute clarifies that “manufacturing shall include…processing…or otherwise extracting from the earth…any natural resource.”

Opinion and Colorado Department of Revenue arguments

The Colorado court of appeals analyzed the statutes set forth above and determined that Pioneer’s pipelines and fittings for their gas gathering system qualify for the enterprise zone sales and use tax exemption because these items of equipment are machinery used in manufacturing. The court found that Pioneer’s pipelines and fittings move natural gas from the wells in a direct production step of extracting natural gas to processing facilities in a continuous flow, meeting the requirements of the exemption because they “are in direct use in the manufacturing of natural gas” within the meaning of Colorado’s sales tax exemption statutes. The court also considered that the enterprise zone exemption statute enumerates “extracting” and “processing” as manufacturing.

The CDOR raised two arguments against the court’s interpretation of the statutes. First, that Pioneer’s gas gathering system is not extracting or processing and should not be considered as directly used in manufacturing. The court declined to get into a highly technical argument over the meaning of the word “gathering,” and while noting that gathering is different than “extracting” or “processing,” the court stated that it “does not change the fact that the pipelines in Pioneer’s gas gathering system move natural gas from one direct production step to another in a continuous flow.” Second, the CDOR argued that the “continuous flow” provision only applies to machinery used “during the manufacturing process.” The court found that the “continuous flow” provision does not include language that limits its application to the manufacturing process, and that natural gas undergoes a manufacturing process, which includes extracting and processing. Thus, the court found both of the CDOR’s arguments unpersuasive.

Sales and use tax assessment for your business

Pioneer demonstrates the inherent tension between competing interests of state government. While taxing authorities aim to broadly construe sales and use tax statutes to enhance their applicability and limit exemptions to raise state government revenues, state governments also have an interest in promoting and incentivizing economic activity in the state. From a plain reading of the Colorado sales and use tax statutes, the Pioneer court ruled in favor of business, and declined to limit the enterprise zone sales and use tax exemption statute. In assessing whether to challenge a state taxing authority’s interpretation of a tax statute or exemption, it is important for businesses to recognize that even though a state’s taxing authority may assess a tax, courts may not necessarily agree with such state taxing authority’s statutory interpretation, as was the case in Pioneer.

State lawmakers not blowing smoke when it comes to taxing E-Cigarettes

The use of e-cigarettes is on the rise, and lawmakers are moving in to regulate and tax them. According to the Centers for Disease Control and Prevention, “about one in five adult smokers tried an e-cigarette between 2010 and 2011.” Most e-cigarette users claim they use them to reduce cigarette consumption or to quit smoking. Much of the concern over e-cigarettes is their growing popularity among youth.

Given the general perception of e-cigarettes as an alternative to cigarette smoking, the taxation of e-cigarettes has been a topic of much debate around the country. Although e-cigarettes contain the word “cigarette,” are designed to look like cigarettes, are inhaled like cigarettes, and contain nicotine like cigarettes, e-cigarettes are not taxed like cigarettes. Furthermore, most current state tax laws do not specifically address e-cigarette taxability. In response to this relatively new product, states have attempted to levy new taxes on e-cigarettes and vapor products.

What is an E-Cigarette?

Electronic cigarettes are battery powered devices that look similar to cigarettes, which heat liquid nicotine to emit vapor. When the user inhales, a white aerosol is emitted that is either odorless or bears the aroma of an added flavoring, such as watermelon, chocolate, or cherry.

Policy debate over taxing E-Cigarettes

The following are a few of the public policy rationales, which state lawmakers rely on when they consider taxing e-cigarettes.

New funding must be obtained to account for declining tobacco tax revenue. At the beginning of 2014, the Surgeon General published a report predicting that the rate of cigarette smoking will continue to decline in the United States.

It is the responsibility of government to regulate and shepherd public health. Proponents advocating this rationale argue that e-cigarettes are just as harmful as traditional cigarettes, and may contain unknown risks, since they are relatively new in the marketplace.

The current taxation of e-cigarettes does not account for intrinsic costs to society. Taxation is necessary to compensate those who do not use e-cigarettes, but must still bear the costs. Examples of costs imposed on society at large would be: inhalation of secondhand vapors, physical and property damage caused by misuse or product defects, and medical costs that taxpayers must endure from detrimental e-cigarette health effects.

Opponents of taxing e-cigarettes counter by arguing:

Taxes on e-cigarettes are likely to place a disparate burden on small businesses while raising limited revenue for states. Opponents note that if state taxes are levied on e-cigarettes, users will simply purchase these products in another more tax friendly state or online to evade the tax.

E-cigarettes provide a less harmful alternative to smoking. If taxes are imposed on e-cigarettes, these products will become too expensive for consumers. Consequently, consumers will continue to smoke cigarettes because switching to alternative and less harmful products will have no cost benefit.

E-cigarette use should be incentivized over cigarette use to reduce the economic costs to the government and public. The health effects of e-cigarette use are inconclusive; however, the use of e-cigarettes is viewed as healthier than cigarettes and e-cigarettes do not pose the same threat as that of secondhand smoke. E-cigarette taxes, opponents argue, will actually increase health care costs by not making them an economically viable substitute for cigarettes.

State taxation of E-Cigarettes

Minnesota and North Carolina are the only states to currently tax e-cigarettes, but nearly half of the states in the U.S. have considered or are considering bills to asses a tax on e-cigarettes. This year alone, bills to enact a tax on e-cigarettes were proposed but not enacted in at least ten states. Proposed e-cigarette tax legislation is currently pending in Michigan, New York, and Ohio. Taxing e-cigarettes is gaining interest in Pennsylvania, although a bill has yet to be proposed.

Minnesota was the first state to tax e-cigarettes by placing the terms e-cigarettes and related products within its definition of tobacco products. North Carolina followed by enacting a separate tax on the nicotine solution consumed by electronic vapor products with a rate of a nickel per fluid milliliter of consumable nicotine solution product.

States considering the adoption of an e-cigarette tax have proposed various means of assessing the tax. Michigan has proposed a tax of fifteen cents per 1.5 milliliters of nicotine solution. New York has proposed a 75% tobacco products excise tax on e-cigarettes. Ohio has proposed taxing nicotine products used with e-cigarettes in the same manner as tobacco.

The proposed Ohio tax is part of House Bill 472 and would classify “[a]ny product that contains nicotine in a cartridge or other component and that is marketed or intended to be used with an electronic cigarette” as “other tobacco products.” E-cigarettes and the nicotine solution used in these products are already subject to Ohio sales tax. While opponents of the Ohio bill are concerned that such e-cigarette tax will stifle small businesses and the bill’s potential to extend to similar products not currently subject to an additional tax, Ohio Governor Kasich hopes to use the e-cigarette tax as part of a plan to provide Ohio taxpayers a $2.1 billion tax cut aimed at individuals and small-businesses.

The future of State E-Cigarette Tax

Just as tobacco users are substituting their cigarette use for alternative products, state governments will seek to substitute their declining revenues from the taxation of cigarettes with alternative sources of revenue. Consequently, it appears the trend is that state governments are attempting to increase taxes on cigarettes and impose taxes on alternative products, such as e-cigarettes. While most states do not currently tax e-cigarettes, despite the similarity they bear to cigarettes, it would appear that more states will be taxing e–cigarettes in the near future.

For additional information regarding these subjects or any other multistate tax issues, please contact:

Businesses must be vigilant and careful in managing their state and local tax liabilities and exposures. We understand this can be a daunting task. McDonald Hopkins Multistate Tax Services provides a broad range of state and local tax services including tax controversy, tax evaluation, tax planning, and tax policy. With professionals who have worked both inside and outside government agencies, our multistate tax team leverages its knowledge and experience to help clients control their complex multistate taxes.